Assets Grow, but So Do Fees

By

David Franecki

Updated Feb. 26, 2001 12:01 a.m. ET

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E ver since mutual funds were established, a few have charged exorbitant fees. But lately, some have gotten downright greedy. These funds have committed the cardinal sin of padding their profits by raising their fees at a time when their asset base is growing. Since the cost of running a portfolio falls incrementally as assets under management grow, this flies in the face of the industry's argument that, by pooling money, funds offer investors an efficient way to venture into the markets.

Barron's asked Morningstar to put together a list of funds that have raised their fees by at least a quarter of a percentage point in the past three years, while expanding their asset base significantly. Remarkably, about 260 funds have that distinction. They've raised fees during some of the bull market's most generous years.

Of the 260 on our list, most have a decent excuse; their assets under management haven't yet hit $50 million -- roughly the breakeven point for the typical fund.

But the other 66 have assets that exceed that total -- sometimes by a very hefty amount.

Invesco Financial Services
,
Invesco European Investment
and
Invesco Energy
, for example, supervise $1.6 billion, $331 million and $212 million, respectively. A spokeswoman for Invesco, which has been one of the nation's hottest mutual-fund shops, blames 12b-1, or distribution, fees. (These are used for advertising and sales promotion.)

Financial Services raised its fee to 1.29% of assets from 0.99% while growing to about $1.6 billion, up from $1.3 billion in the past three years. European boosted its fee to 1.52% from 1.25% while growing to $786 million from $331 million. And Energy hiked its fee to 1.6% of assets from 1.21%, while growing to $436 million from $212 million.

Strategic Income, the biggest of the trio, raised its fees to 0.75% of assets, up from 0.23%, while growing its asset base to $253 million from $102 million three years ago. The fund mostly owns domestic junk bonds and emerging-market bonds and has performed well relative to its peers. The other two Franklin funds are state-specific muni funds. A Franklin spokeswoman says the fees have climbed because the firm removed expense caps, also called "fee waivers," which is a natural part of a fund's growth. However, the funds weren't that small even three years ago, so pulling fee waivers shouldn't have been an issue at their size.

Three Armada funds also landed in our hall of shame --
Armada Total Return Advantage
,
Armada Limited Maturity Bond
and
Armada Ohio Tax Exempt
. Armada, based in Cleveland, runs 28 funds with a combined $16 billion in assets. A spokeswoman says Armada raised the fees because the funds were converted from trust funds and given a grace period before the fees kicked into a more mutual-fund-like level. The funds are run by National City Investment Management.

Another member of the list is
Morgan Stanley Dean Witter Total Return
, which raised its fee by 0.81 of a percentage point in the past three years, even though its portfolio swelled five-fold in that period, to $731 million.

Also worth noting: Fees on Class C shares of
State Street Research Aurora
jumped to 2.21% from 1.16% three years ago. Although the fund is a good performer, its fee is now more than double that of the average U.S. diversified fund.

Costs should go down when a fund gets bigger because funds' expenses are relatively fixed. They must pay fund managers and analysts, have computerized research and trading capabilities and a certain amount of fund accounting, or "back office," operations in place. Those account for the bulk of the costs.

As a fund pulls in more assets, the fixed costs are spread over a much wider pool of money, effectively taking a smaller percentage of the fund's revenues. Some marginal costs -- for, say, communicating with shareholders or providing service -- might go up, but these usually are relatively modest.

The fact that so many funds have raised their fees while growing bigger disturbs some financial advisers. Says Harold Evensky, a planner in Coral Gables, Florida: "I think it's unconscionable. I can't imagine what the explanation is." Evensky, who in 1998 testified before Congress about mutual-fund fees, is directing some of his clients out of mutual funds and into separate accounts and exchange-traded funds, in part because he's fed up with fund fees. "I want to know when I'm paying a manager for their brains," Evensky grumbles. "It bothers me when they have, in effect, built higher profit margins in."

Most mutual-fund investors are only casually aware of the fees they're charged. If they are, it's only in vague percentage terms and seldom spelled out for them in dollars. But even those that were paying attention found it hard to hold a grudge when their fund was returning 30% a year. But now, with times much leaner, fees could come under the microscope, says Russel Kinnel, an analyst with fund tracker Morningstar. "Until the last year, fund investors were kind of signaling they didn't care about expenses, manager experience or risk." Now, "more investors are becoming aware of the costs, but it's still kind of a hard sell with people."

I n addition to being zapped by troubled financial markets, it appears that
Charles Schwab
is about to be hurt by its clients' return to investing in funds, rather than individual stocks, and harmed as well even by its own message. The San Francisco firm recently reported that revenues from client trades were down 26% in January, compared with the year-earlier total. However, business has boomed at Schwab's giant Mutual Fund OneSource. Clients put more than $4 billion to work in mutual funds through Schwab in January, including record bond-fund inflows of $922 million. In a press release, Schwab co-CEO David Pottruck trumpets his fund business's success, pointing out that January's inflows were the second-highest in the company's history.

But this isn't good news for Schwab's bottom line, says Lehman Brothers analyst Mark Constant. In the short term, Schwab will be hurt as its clients morph from frequent traders into buy-and-hold mutual-fund investors. Schwab generates higher fees from individual stock trades than from fund transactions.

Some of the damage to Schwab is self-inflicted. Schwab officials have said publicly that the firm is encouraging investors to move toward investment concepts and away from mere trading. Many of Schwab's materials promote the "core and explore" investment philosophy, which includes putting the bulk of an investor's money in index funds and using the rest to try to outdo them. The paradox for Schwab is that as its clients increasingly follow the firm's advice, Schwab's profitability takes a beating. Are customers starting to listen? Constant asks. "If they are, that's not necessarily the best thing for Schwab's 2001 earnings."

A Schwab spokesman says the firm isn't doing anything new by encouraging long-term investing, although he won't discuss the short-term implications of decreased trading. "If our clients follow our suggestions, our principals of long-term investing, they'll be successful and Schwab, in turn, will be successful," he maintains.

L ike clockwork, as soon as a certain type of mutual fund has had a run of outperformance, you can expect similar funds to roll out.

Consider value funds. After soundly outperforming their growth counterparts last year, they're back in vogue, and some of the biggest fund outfits, including Fidelity and Janus, plan to launch more.

Lou Harvey, president of financial services research firm Dalbar Inc., notes that mutual-fund buyers are notorious performance chasers, and says it's only fitting that fund companies give them something to pursue. And this time around, he views the phenomenon as rational. After investors' decade-long love affair with growth funds, "the interest in value funds is a return to sanity," Harvey asserts.

The new Fidelity fund, Fidelity Advisor Equity Value, will invest in stocks viewed as undervalued relative to assets, earnings growth potential or cash flow. It will be run by Stephen DuFour, who piloted
Fidelity Equity Income II
for the past year and Fidelity Balanced before that. In the 12 months ended February 15, Equity Income II gained 15.56%, which placed it in the middle of its pack, according to Lipper Inc. The new Fidelity fund will charge a stiff 5.75% upfront sales load for Class A shares and smaller fees for other share classes. Its annual management fee will be 0.58%.

Janus, a bastion of growth investing, made waves by launching its first value fund, Janus Strategic Value in February 2000. It has since vacuumed up $3 billion in assets. The firm's new offering, Janus Adviser Global Value, will be for institutions only. The fund will be run by Jason Yee, who rejoined Janus last year after a four-year stint at little-known Bee & Associates. The fund won't be diversified, which allows it to make bigger --and riskier -- bets. Janus Global Value will charge a management fee of 0.65%, plus a distribution fee of an additional 0.25%.

Another fund titan, Putnam, has a new value fund -- Putnam Mid-Cap Value. It will be co-managed by Edward Shadek and Thomas Hoey. Shadek is also manager of Putnam's small-cap value fund, which has climbed 28.42% in the past 12 months, placing it in the middle of small value funds tracked by Lipper.

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